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January 2, 2012

How to Capitalize on the ‘January Effect’

Surprising advice from a behavioral economist

Can traders capitalize on the 'January Effect?' (Photo: AP)

Renewed optimism that drives resolutions to lose weight, stop smoking and save money also affects market performance, according to Stephen Ciccone, a professor of finance at the University of New Hampshire. And just as this hope too often wanes in the days and weeks following the New Year celebration, so too does market performance.

Traditionally, markets rise during the month of January, something economists have appropriately dubbed the “January Effect.” But is optimism solely the reason, or do other factors apply? Ciccone, writing in The Washington Post, credits a combination of reasons, but notes optimism is a major player.

“Two popular hypotheses try to explain [January's] unusual returns,” Ciccone explains. “One is ‘tax-loss selling’–the notion that investors sell stocks in December to generate capital losses for their tax returns, then buy them back in January, pushing up prices temporarily. The other, ‘window dressing,’ contends that money managers sell risky holdings in December to make portfolios look safer when reporting to clients. After the ball drops, they buy back what they sold, pushing January prices up.”

Both explanations have their supporters, he writes, but “neither adequately accounts for the January Effect.”

Cheap stocks whose prices rose during the year are unlikely to be sold for tax reasons, and they do well in January. Meanwhile, window dressing does not appear to occur during midyear reporting dates. If money managers were doing this at the end of the year, they would probably do it in the middle of the year, too, he notes.

“January optimism fills the gaps in these theories,” he concludes. “I found that small stocks, such as those with market caps below $1.5 billion in the Russell 2000 Index–think Starbucks before the latte craze–were particularly predisposed to its influence. Because they are considered risky, temporarily optimistic investors bet on them at the beginning of the year. When reality sets in, these holdings get dumped.”

January optimism is sentimental, he adds, which is generally ignored by academic researchers who frown upon claims that clash with their ideas of market efficiency.

So how can investors take advantage of the January Effect? Follow the herd, Ciccone says, a surprising suggestion from a behavioral economist.

“Follow the herd and be optimistic–purchase cheap, long-shot small stocks in December, and sell them before they tank in February,” he writes. “Of course, there is no guarantee that the January Effect will continue. Then again, there’s no guarantee that those who promise to read 'War and Peace,' practice yoga or call their mothers every Sunday won’t be hard at work on their resolutions 30 days from now. Odds are, however, that January optimism will wither–stock prices will fall, Tolstoy’s weighty tome will go unread, yoga mats will gather dust, and Mom will wait by the phone.”